ITC Equity research report

Should you be Investing in ITC shares for the long term ?. This is a question on most Indian investors mind when a discussion happens about long term investing. Whenever i have been part of such a discussion which is way too often for my liking. The answer is quite simple IT DEPENDS ON THE PRICE at which you buy. This answer makes it imperative to value ITC – The biggest Cigarette Manufacturer in India.The report takes a look at what the future holds for ITC shareholders. And if there is enough value for an investor to buy shares to create long term wealth and at what price it is a valuable buy.

Setting the Table:

 

Before we begin our valuation of ITC; it is important to observe the facts, economy, industry outlook, financials, past performance and competitive advantages. After analysis, each section will form assumptions leading to our valuation.

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1)Key Facts :

 

  1. ITC is the biggest cigarette maker in India.                                                             
  2. ITC has close to 80% market share with 4 out of every 5 cigarettes sold in India belonging to ITC.                                                                                                  
  3. Cigarette demand is inelastic in nature.                                                                  
  4. 75% of ITC’s revenue comes from cigarette sales and 25% from other businesses.     
  5. Other business verticals of ITC are FMCG , Hotels , Agri Business , Paperboards & Papers , Information Technology and Packaging.                                                     
  6. ITC has one of the strongest managements in India with a long history of paying dividends.                                                                                                            
  7. Rural demand and Monsoons are crucial for ITC’s Growth.                                            
  8. Cigarette demand is non-elastic in nature.                                                                       
  9. ITC has a strong distribution network with approximately 2 million retail outlets.                                 

2)Cigarette industry in India.

 

The cigarette industry is one of the oldest industries in India. It is an important agro-based industry. It is labour intensive industry and provides livelihood directly and indirectly to many rural workers. Cigarette is an item which requires industrial license before setting up the industry as per Industries Act,1951 (India). India produced 8176 Crore cigarettes in 2014-15.

In 1991, when the government delicensed a majority of goods, it decided to maintain restrictions on issuing licenses for fresh capacity for alcohol and tobacco. Foreign direct investment in the sector is prohibited.The percentage of smokers is going down due to increased awareness on harmful aspects of smoking. Due to high taxation on legal cigarettes more people in low income areas are using alternatives like beedis and illegal cigarettes.India ranks 159th in the world with 110 cigarettes per person per year.

World over despite of declines in smoking rates, number of smokers and cigarettes rises.

 Assumption 1 : The entry barriers to the Industry is high and there is no threat of new entrants in the medium term future.

2.1) Consumer Trends and Behaviour:

 

As per the WHO (World Health organisation) India has 132 Million smokers as of 2015 rising from 120 Million in 2010. The past trend for last 20 years suggests that number of smokers are increasing at the rate of 2-3 percent a year. This has a close correlation to the growth in population which is growing at 2-2.5 percent per year. Studies find that prime factor for most people to take up smoking at an early age is Peer pressure and Depiction of Smoking scenes in movies (following their role models). Access to Cigarettes is another key factor. Studies show that availability is one the most important factors which drive consumer behaviour ( Coca Cola if made available to a person more often the consumption will go up).

Furthermore smoking is more prevalent and associated with lower socio-economic groups. Effect of taxation is discouraging most to the poor. Beedis accounted for 48% of Indian tobacco consumption in 2008. Beedi smoking tends to be associated with a lower social standing, and these tobacco-filled leaves are inexpensive when compared to regular cigarettes.Those with a high social standing who do smoke beedies often do so out of the public eye. Brand Loyalty is very high cigarette smokers. Unless there is a significant difference in price of a competitor brand one does not switch easily.

 

Assumption 2 : Number of Smokers in India will rise between 2-3 percent per year.

2.2) In Film and Bollywood

 

76% of movies in Bollywood as of 2016 contain smoking scenes. Now even though there are signs saying smoking kills, Psychological studies show that it reinforces the idea that smoking is normal behaviour. In-fact smoking is associated within Bollywood with something the Hero or role model does. This has a far reaching effect on youth and teenagers who tend to mimic role models and take up smoking from an early age.

 

Assumption 3 : There is a  positive co relation between number of smoking scenes and depiction in Bollywood Movies and smoking adoption over a medium term.

3) Government Regulation and Taxes on Cigarettes.

 

Due to health reasons the government continues to impose additional restrictions and taxes on the cigarette industry year on year. Smoking prohibition laws are considered quite weak in India compared to other developed economies like the U.K and U.S. The government has proposed the Sin tax in GST of close to 40%. ITC  says that taxes on cigarettes in India are the highest in the world if you take it in light of per capita incomes.

ITC claims that Tax/per caipta ratio in India is 8-10 times that of the USA. Due to high taxation on cigarettes there are many arbitrage opportunities for illegal cigarette importers. As per capita income increases more people will be able to afford legitimate cigarettes. Every fifth cigarette in India is tax evaded. Legitimate cigarette share of total tobacco consumption has dropped to 11% from 21%. With the rollout of GST it is expected that illegal cigarette sales and consumption will be curbed as they will be forced to come under the tax net.

 

Assumption 4 : The Government will continue to Tax cigarettes more and more each year due to health concerns and to increase its tax revenues.

Assumption 5 : GST Rollout will reduce illegal cigarette sales as they will come under tax scanner. this will benefit ITC (legitimate cigarette makers ).

4) India Economy.

 

With the Indian economy slated to grow at 7-8% till 2020 and 5% post 2020 till 2025 (World bank estimates). One can deduce that as the Indian Economy grows per capita income will rise which in turn should support the growth in per capita cigarette consumption.Thus there is some support for cigarette companies in India to grow as more and more people will switch to consuming cigarettes as against traditional alternatives like beedis. Add to this a population growth of 2% per year on 1.2 billion population base which is set to overtake that of China by 2025.Thus one can assume that as India’s per capita income will grow,with that the cigarette consumption will also grow inspite of additional taxation.Add to this a population growth of 2% per year on 1.2 billion population base which is set to overtake that of China by 2025.

 

Assumption 6 : India economy will grow at 7-8 % till 2020 and 5 % from 2020 to 2025.

Assumption 7: As per capita income rises in India more people will switch from substitutes like beedis to cigarettes.

4.1) Impact of Monsoons on Growth.

 

As is the case with most FMCG companies , monsoons and rural demand are important factors for revenue growth.

4.2) Drought Years.

 

As we have seen previously in our Equity research of Colgate India , the years 2015 and 2016 being drought years have impacted the revenues of FMCG companies. I would expect significant percentage of ITC’s  revenue growth  to come from rural demand.While considering rural demand,most noteworthy is the fact that the past 2  years F.Y. 2015 and F.Y. 2016 have been drought years. During the period 1871-2015,there have 26 drought years.Thus based on this historical data there is a 18.3% probability of drought in India each year. India has experienced  droughts 5 times in 2 consecutive years  which means a probability of 3.5%. And once three years have consecutively been drought years having a probability of 0.7%. Thus based on the above data , there is a strong probability of 92.3% of good monsoons in F.Y. 2017.

 

Assumption 8 : Monsoons affect ITC’s Revenue Growth.

5) Non Tobacco Businesses of ITC.

 

Approximately 25% of ITC’s revenue comes from Non Tobacco Businesses. ITC has been trying very hard for past many years to reduce the company’s dependance on cigarettes as prime source of Income . Here is list of Non tobacco business verticles of ITC.

  • FMCG.
  • Packaging.
  • Paperboards & Specialty Papers.
  • Hotels.
  • Agri Business
  • Information Technology.

 

When it comes to the Non-Cigarette business of ITC. The company has made over 25000 Crores of Investments and has projected that it will have a revenue growth of 17% per annum till 2030 taking it to 1 Lakh crores.

As of now ITC has a minority market share in all of its Non-Tobacco business . Thus we will be taking the 17% per annum projected revenue growth till 2030 from Non tobacco business at face value and build it in our valuation.

 

Assumption 9 – ITC’s will be able to achieve its target of 1 lakh crore revenue from Non Tobacco Business till 2030. With the Non  Tobacco Revenue growing at 14-17% per annum.

8) Analysis of Financial Statements.

 

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ITC has a very good financial track record. As with most FMCG companies in India , ITC earns a high return on equity.A high return on equity record signifies the management’s ability to reinvest its earns in profitable ways.

The company has no debt which protects it to a significant extent against interest rate risk.ITC has had a track record of retaining on an average around 45-47% of its earnings. The rest is paid back to shareholders in form of dividends.This signifies that the company has been operating as a mature company. Therefore it seems like that in times of increased competition and poor monsoon (lack of demand) , ITC is financially stable to deal with this as it has strong cash flows. ITC operates on a negative working capital and has been able to maintain this for the past decade. Negative working capital is good news as suppliers pay in advance and company has enough cash which can be invested for growth.

8.1) Revenue Growth

 

The revenue growth for ITC has also been mostly stable with a dip in 2015 and 2016.

It can be observed that in 2015 and 2016 revenue has dropped however profit margin have sustained. Furthermore with respect to revenue it seems sticky with no de-growth happening in spite of drought and increased taxation.

While comparing both revenue growth and profit margin we can draw conclusions that the management is focusing on profitable and sustainable growth. Going forward, we can expect ITC to continue growing its revenue and maintaining profit margin inspite of more taxation on cigarette. Another insight from the revenue growth over the years is that the cigarette consumption does not decrease and infact revenues go upwards with increased taxation.

8.2) Profit Margins

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Another noteworthy trend which emerges from the profit and loss statement is the profit margins. 

The EBIT margins of ITC are in range of 35 percent. In 2016 even though the revenue growth slowed down to 2 percent due to 2 years of bad monsoons and high taxation on cigarettes , the company was able to increase profit margin to 37 percent. This provides evidence that ITC has strong pricing power and inspite of increase in taxes in future it will be able to pass on the cost to the consumer.

8.3) Capex and Reinvestment

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A high return on equity means that ITC has few tangible assets which generate a significant amount of revenue. In order to maintain its current revenue and grow it in the future, the reinvestment in tangible assets is around 5% of its revenue each year. Furthermore, going ahead in future years I believe a major asset of ITC will be its brand names in FMCG which requires a significant amount of advertising monies to be spent each year. To gain market share in Non FMCG   and  increase brand equity , I feel ITC will need to spend 31% of its Non Cigarette revenues on advertising  The positive impact of advertising spends, though not immediately, will result in revenue and higher margin over a longer period of time.

9) Valuation of ITC.

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Almost always as is the case with predicting future earnings , there are many possible outcomes. Therefore a scenario analysis is important. After considering all factors our valuation reflects Average Per Share value of 413.24 Rs per share with a company valuation of 3,30,863 Crores INR.  A range of Rs 209.95 to Rs 553.15 Rs per share value was discovered as a result of conducting scenario analysis on our assumptions.

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Please note :Based on the discussion and assumptions above we built the following in our valuation :

  1. The Cigarette Business of ITC will grow at 8-10 percent per Year till 2030.                
  2. The Non Cigarette Business will be grow at 15-17 percent till 2030 per year.             
  3.  ITC will be able to sustain its Profit margins (EBIT) at 35-36% inspite of increase in taxation.                                                                                                              
  4. ITC will reinvest close to 5.1% of its revenues for future growth each year.

10) Recommendation.

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“The current market price of 240 Rs as against the valuation of 413.24 per share.Therefore we feel that ITC is undervalued by 41% which is a margin of safety as an investor. In conclusion , A long term investor can start buying at current levels of 240 Rs (as of 22nd October 2016)  and keep adding if price goes down in the short run”.

Please note that the valuation will be updated each quarter. As also will any news impacting any of the assumptions or factors in ITC’s valuation.so STAY TUNED.

 

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